Back to the 1960s: Fed’s dot plot may signal dark economic times

The economy is stuck at levels last seen since the Cuban missile crisis.

WASHINGTON (MarketWatch) — A key interest rate that helps lubricate the U.S. economy might remain stuck indefinitely at levels last seen since in the Cuban missile crisis, if the Federal Reserve has connected all the “dots” correctly.

The Fed might take a step this week that suggests the U.S. economy’s long-term prognosis is even more fragile than previously believed.

Many forecasters say the central bank could lower its long-term target for the so-called fed funds to 2.75% from 3%, based on the so-called dot plot that reflects how senior Fed officials see the economy. Wells Fargo, Bank of America Merrill Lynch and BMO are among the Wall Street firms that believe another downgrade is coming.

The last time the effective fed funds rate consistently topped out around 2.75% was in the early 1960s, but that was a time of much stronger economic growth. Such a low ceiling now would illustrate more pessimism about the economy’s future ability to grow.

“It’s a reflection of the challenges the economy faces following the last downturn,” said Sam Bullard, senior economist at Wells Fargo Securities. “What we are finding out is the potential speed limit is lower than it has been in previous historical periods.”

No kidding. Just two years ago, the central bank was expecting the fed funds rate to eventually end up around 3.75%. Even that’s much lower than the 5.25% peak near the end of the last economic expansion from 2001 to 2007.

The fed funds rate is now set at a range of 0.25% to 0.5%, barely above an all-time low.

The dot plot will probably also show the Fed only expects one interest rate hike this year, and perhaps fewer than previously planned in 2017 and 2018.

“More telling is how much the dots are lowered in future years, likely by a quarter point,” said Douglas Porter, chief economist of BMO Capital Markets.

To complicate matters, the Fed could actually raise rates this week or at the very least signal it will raise the fed funds rate before the end of the year. Normally the Fed only raises the rate when it thinks the economy is healthy enough in the short term to handle one.

#Fed#FOMC is expected to keep rates steady although “dot plot” is still likely to show yearend rate hike

Why the contradiction between the Fed’s current and future views of the economy?

The Fed views strong job gains that have pushed the unemployment rate below 5% as a sign the labor market is finally near full strength more than seven years after a recovery began. The bank’s leadership sees an upward tilt in wages and income, historically low level of layoffs and chronic complaints by business about a shortage of skilled labor as harbingers of higher inflation.

At the same time, though, the growth of the economy has not matched the progress in the labor market. Key industries such as manufacturing and energy are struggling, exports have fallen and business investment is weak. Those are some of the main pillars of the U.S. economy.

As a result, the U.S. grew barely 1% in the first half of 2016 and it’s on track to expand less than 2% in 2016. That’s why a handful of senior Fed officials are still not keen on raising rates.

Indeed, the Fed’s periodic “summary of economic projections” to be issued Wednesday is all but certain to lower the bank’s median U.S. growth forecast for this year, perhaps to as low as 1.6% from 2%, Nomura Securities predicts.

That’s well below the nation’s historic growth rate of 3.3%. A much slower rate of growth, in turn, means the average American’s standard of living is not increasing as much as it did in the past.

The persistent underperformance since 2010 is why the Fed has been forced to lower its forecast for how fast the economy can grow in the long run. The bank has repeatedly cut its projections and it now figures 2% is the economy’s speed limit. Fed officials could cut that another notch this week.

That’s why the fed funds rate won’t be raised as high as it was in the past. It won’t take much to rein in an economy that expanding at the slowest rate in modern history. The challenge for the Fed, and perhaps more critically political leaders in Washington, is to take action to rewrite the script for the economy’s future.

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